Volatile Commodities and Inflationary Expectations

Last week's big tumble in commodities and this week's volatility have filled headlines. The pundits seem to agree that the drop was precipitated by a large increase in the margin requirements for silver futures. The initial margin on new futures positions has now been jacked up by about 400 percent.

So why would a commodity exchange raise margin requirements on silver and other commodities by such a hefty amount? We think it has a lot to do with the U.S. Federal Reserve's desire to keep interest rates low. In our opinion, inflation expectations loom large over the margin increases on U.S. purchasers of silver, oil, and corn. The move reflects a concerted effort to put a brake on the speed of rising prices. Exchange managers, regulators, and other U.S. policymakers are teaming up to keep inflation expectations in check and are trying to keep markets orderly. Similar action was taken in the U.S. during the 1970s, when oil and gold were making big upward moves. We have also seen this at play in other countries where officials have attempted to manage inflationary expectations

Higher margin requirements and trying to manage the commodity markets in this manner have unintended consequences: trading activity will migrate to commodity bourses in other countries. Here's another example of how the U.S. is eroding its leadership in financial services.

The Federal Reserve is betting big here. The economy needs low interest rates to have any chance of improving the employment picture. The Fed is betting it can maintain very easy monetary policy and keep interest rates very low "for an extended period" and do so without letting an inflationary psychology take hold. Why? Because inflationary expectations are "well anchored," to use Fed language.

We strongly disagree with this notion. Most people we talk to believe that inflation is clearly a current and future problem. The public appears savvy about what's happening to their cost of living and their behavior is starting to show it. Whether Americans are motivated by fear of further price increases, by looking backward and then extrapolating recent rises in food and gasoline prices into the future, or by some visceral distrust of policymakers' ability to accurately gauge and effectively control future inflation, they expect food and energy costs to stay high and head even higher. Inflationary expectations are hardly as well anchored to low levels as the Fed thinks.

Inflation: How Expectation Turns to Fact

Nobel Prize economist Milton Freidman pointed out in 1967 that the level of inflation that people expect eventually becomes the inflation rate. His theory has since gained textbook status. Workers who expect inflation bargain harder for wage increases. Then companies institute price increases to reflect their anticipation.

In many other parts of the world, inflation is a festering tax with which authorities, businesses, and consumers alike are currently grappling. Their behaviors demonstrate that many of them expect it to continue as demand for more protein and a higher standard of living pushes demand for oil, food, and precious metals.

Regulatory Manipulation

In the short-term, commodity margin hikes may force some speculators to sell and even decrease volatility over the long run as fewer players participate in the market. However, the U.S. futures market for silver and oil is a mere fraction of overall global trading in these commodities. A change in the degree of leverage and speculation in one country may have a short-term effect on world prices, but the long-term impact is marginal.

We expect the upward march of gold and oil to continue. We used the decline to add positions in gold and oil, and we continue to be bullish on both.

Expect to see more announcements and edicts from officials that are meant to discourage those want to make money or protect themselves by investing in, buying, or hording, commodities and related shares. Look for these kinds of actions:

More margin increases in food-related, precious metals, and energy commodities in months to come,

Position limits in certain commodities, especially for non-commercial hedgers who do not need to trade commodities as part of their business,

Commodity trading price restrictions: For example, last week, when oil futures were falling, the Chicago Mercantile Exchange officials changed the daily maximum decline limit from $10 to $20…but just for that day. Why would they make a special case like this?

Disinformation campaigns about commodities "bubbles",

Eventually, there will be campaigns suggesting that ownership of commodities is unpatriotic.

China Setting the Table for Yuan as a Reserve Currency

Hong Kong is trading more bonds denominated in Renminbi (Chinese mainland legal tender) as part of Beijing's two-year-old campaign to internationalize its currency. It is much cheaper to float Renminbi bonds in Hong Kong. Issuers can save several percentage points on the interest rate that they pay by floating the bonds in Hong Kong rather than in mainland China. Accordingly, there is growing demand from large companies in Asia, China, and Europe to issue these Hong Kong bonds to help fund their Chinese operations. This increased bond issuance is a big step toward creating a wider and deeper bond market in Chinese currency. A deep, liquid bond market is a must for an effective reserve currency.

Over the years, a great deal of money has found its way from China to Hong Kong, and Renminbi trading activity is growing rapidly. Chinese and multinational players need a vehicle for investing the money, thus a bond market is emerging. The next step is to have currency convertibility spread throughout the Chinese banking system.

Currently, the Chinese hold about 1.15 trillion dollars of U.S. debt securities. In the first quarter of 2011, China announced that they will continue to gradually dispose of their U.S. treasury securities and diversify into the securities of other nations. This bodes well for the Renminbi, but not so well for the U.S. dollar.

Cut Spending or Else! The Deficit Seriously Threatens U.S. Future

Two weeks ago we alluded to the future of the U.S. and how the standard of living might fall when we lose the imprimatur of world reserve currency. We are harping again on this theme, and by doing so hope to awaken our American readers to the fact that they must use their influence to encourage their government representatives to take immediate action.

Toward that end, we are attaching a link to an article about a recent speech from Paul Volcker , who is remembered as the Fed Chairman who pulled the U.S. us out of its inflation in the early 1980′s. Mr. Volcker had consistently warned of derivatives and leverage problems at banks before the crash of 2008, and now he continues to warn the public about the U.S. debt situation. Is anyone listening? http://ca.news.yahoo.com/volcker-warns-danger-u-deficits-021208098.html

Similarly, Europeans need to demand fiscal discipline from undisciplined European countries. Europe should strongly resist the irresponsible actions of some nations. Instead, they and their banks should be dealt with firmly. Action should be taken as soon as possible as well.

Dollar Rallies Modestly

The dollar has been steadily declining for months and along the way hitting new lows versus the rest of the world's currencies. In the last week it has staged a modest rally. We believe that it will be short lived. Before the end of 2011, we expect to see further upside in the Australian, Singapore, and Canadian dollars, the Swiss Franc, Thai baht, Brazilian real, and Chinese yuan.

We do not favor the yen or the Euro. They share many of the same ailments beleaguering the dollar. If there is any comfort, know that the dollar is not heading down the debt-laden road to perdition alone.

Selling Oil Stocks for Fear of Demand Destruction May Be a Mistake

If you are not watching global oil supply and demand figures, you may think that higher prices are reducing demand for oil. You would be mistaken. Oil demand is still rising, not falling.

Here are a couple reasons why we believe that oil prices can go substantially higher.

1) Hugo Chavez

Venezuela's lower oil production will cut supply in the U.S., which is Venezuela's biggest customer. President Hugo Chavez is still up to his shenanigans. In 1998, the year before he took control of the country, Venezuela produced 3.2 million barrels per day. In 2010, the figure was less than 2.4 million barrels. During his rule, he has fired and alienated almost all of the qualified professionals from the state-owned oil company, and has taken control of the company for his own political purposes.

Now, leading up to the election in 2012, he wants to impose more taxes so as to have more largesse to hand out to the poor. The lower class has not seen its standard of living improve under Chavez in spite of his many promises. In fact, the standard has actually fallen during his regime. Very much like his friend Fidel Castro in Cuba, Chavez has weakened the national economy and lowered the standard of living for most Venezuelans.

After changing the constitution to allow himself more terms as president and failing to lift the great majority of the people of his country out of poverty, he is now blaming oil companies for his failures. So he has decided to raise taxes on oil producers in Venezuela. Oil companies will have to pay a 90 percent tax on oil sales between $90 and $100 per barrel, and if the oil sales price tops $100 a barrel, a 95 percent tax will be imposed.

Major oil companies will probably cut production…a bunch. That's bad for Venezuela. Income will fall. It is also bad for the U.S. which imports a great deal of crude from Venezuela, and it's especially bad for the specialized refiners in Texas structured to refine the heavy and sour crude oil imported from Venezuela. If refiners do not get supplies of oil to convert into gasoline, gasoline prices rise.

2) Abiding global thirst despite higher prices

Other currencies have been rising versus the U.S. dollar, which has cushioned their economies. As an example, the Australian dollar has risen 23 percent versus the U.S. dollar in the last 12 months. The price of oil has risen by 31 percent in U.S. terms. Therefore to Australians, crude oil is only up about 8 percent.

Gasoline prices in many places around the world (think Europe) have been $8 per gallon or more for some time, so $1 more per gallon is a 12 percent increase. In the U.S., however, a $1 increase per gallon is a nearly 30 percent increase. Also, in Europe the public moves more cost-effectively. The Europeans are more prepared. They have smaller, more fuel-efficient cars and trucks as well as more mass transportation options.

In many countries — India is an example— the government subsidizes the price of oil and energy so demand is very slow to change.

Most importantly, the war in Libya and the disturbances in Bahrain, Syria, Iran, Yemen and many other countries in the region are not going away. We expect a lot more fighting in the region before 2011 winds down.

In summary, the price of oil outside the U.S. has been rising, but much more slowly than in the U.S. Why? Because their currencies are rising versus the U.S. dollar and therefore the price of oil in their currency is not rising as rapidly. In the U.S., prices of oil and gasoline have risen much faster given the weak dollar. This will lead to a decrease in incremental demand in the U.S., but demand in Asia is still booming and in no danger of slowing down soon.

We have researched hundreds of energy-related companies looking for good investment candidates and have found several that both benefit from rising energy prices, and that also pay high dividends to shareholders. Investors are attracted to shares that have upside potential and steady income.